One news item I didn’t miss on St. Thomas – and rather wish I had – was Janet Yellen’s reassurance regarding the likelihood of another financial crisis. Here is the full quote.
Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer, and I hope that it will not be in our lifetimes and I don’t believe it will be. [emphasis added]
I disagree with almost every word in those two sentences, but my belief is less important than Chair Yellen’s. If she really believes this, then she is oblivious to major instabilities that still riddle the financial system. That’s not good.
She may be right in that the future financial crisis will not look like the last financial crisis, at least in the United States. We have repealed the law passed under George W. Bush that allowed major banks to lever up 30 to 1. (What were they thinking?) We have required banks to recapitalize and to reduce their market-making activities in the bond market, theoretically reducing their risk of insolvency. And we have put in place all sorts of profitability- and productivity-reducing regulations. While these may be appropriate for larger financial institutions, they are choking the life out of smaller community banks, and thereby reducing the availability of capital to small businesses. Is it any wonder that we are seeing more businesses failing than being launched?
But like generals fighting the last war, central bankers will find that the next financial crisis will be fought on different fronts, with entirely different components and opponents. There is an appalling lack of liquidity and market-making available in the major fixed-income markets, something the banks used to provide, and now by regulatory statute they can’t. Oh, everything is just fine right now, but the moment we hit a speed bump, the liquidity and market-making capability that is left will simply dry up.
In theory, the Fed probably can’t provide liquidity for that type of market, but I will bet you a dollar to 47 doughnuts that they will find some loophole that authorizes them to step in somehow; otherwise there will be a spiral downward in the debt markets. Some markets will spiral up, and some will spiral down. We have once again created all kinds of new debt instruments as investors reach for yield in this low-rate environment, and there will simply be no market liquidity for them in a crisis. A flight to safety will ensure that long-term Treasury rates will plunge to levels that we have not yet seen.
I could list other imbalances in the financial markets, but you get the picture.
Financial politicians (which is what central bankers really are) have a long history of saying the wrong things at the wrong time. Far worse, they simply fail to tell the truth. Former Eurogroup leader Jean-Claude Juncker admitted as much: “When it becomes serious, you have to lie,” he said in the throes of Europe’s 2011 debt crisis.
They lie because they’re afraid of the impact the truth will have. This is a problem, because markets can’t function on false information, at least not indefinitely. The best thing for everyone is to let markets adjust naturally, even though confronting reality can mean short-term pain for some participants. And sometimes it does make sense to cushion the blow. It doesn’t make sense to cover over a problem for years, let it get bigger and bigger, and postpone acknowledging it until the worst possible time. Yet that’s what usually happens.
In fairness to the financial politicians, they often deal with situations where all the choices are bad. More often than not, that’s because their predecessors made similarly bad choices under similarly difficult conditions. The string of mistakes goes back decades. That is our situation today. We think governments and central banks are powerful, and they are in some ways, but they aren’t omnipotent. They don’t have monetary magic wands.
They also face enormous pressure to “do something,” even when the right thing is to do nothing and just let the market clear.